Beware the Bear Flag in IWM

by Tyler Craig | October 3, 2012 10:57 am

Oh, what a tangled web Mr. Market weaves. Sometimes the path of least resistance is easy to discern, and profitable trades fall into your lap like daily gifts from the market gods. Other times crosscurrents muddle the market broadcast, generating all sorts of conflicting signals. A chart of the broad market may present equally compelling bullish and bearish patterns — the key lies in preparation and the anticipation of all potential scenarios.

While the slide in the iShares Russell 2000 (NYSE:IWM[1]) was finally halted by the formation of support in the $83 area, the ensuing bounce has been lackluster at best. The upward sloping channel has taken on the form of an ominous pattern: the bear flag. As the name implies, the bear flag typically heralds lower prices. In other words, the past few days of slightly upward movement may give way to yet another impulse move lower.

Click to EnlargeTraders might consider adding a few bearish plays to their portfolios to hedge existing bullish trades that may come under fire in the coming days. One higher-probability approach is selling out-of-the-money bear call spreads.

Traders willing to bet IWM remains below $86 through November expiration could sell the Nov 86 call while buying the Nov 91 call for a net credit of $0.80 or better. The max reward is limited to the $0.80 received at trade inception and will be captured if IWM stays below $86. The max risk is limited to the distance between strike prices minus the net credit, or $4.20.

To minimize the potential loss, you could exit the spread if IWM rises above the upper bound of the bear flag pattern, around $84.60. Such a lift would negate the flag and signal the uptrend is back in full force.